January 16, 2010

The risk externality

PRESIDENT OBAMA has made news by making it known that he is considering a bank tax of some sort, ostensibly to help recoup the cost of the government’s financial interventions. It’s not clear what kind of tax might be in the works. The administration has previously expressed a lack of interest in either a transactions tax or a special tax on bonuses, though those might have found their way back on the table. According to the New York Times‘ Jackie Calmes, the lead contender at the moment is a tax based on bank size, or some combination of size and interconnectedness.

Much of the discussion of the tax on the economics blogosphere has concerned the likely incidence of such a tax (see this and this)—would a bank pass on the cost of the tax to taxpayers? Interest in this angle likely stems in part from recently related news that London firms were largely absorbing the cost of the special bonus tax and paying bonuses out in full.

It’s an interesting point, but not the most important one, which is that a tax on size would seek to correct for the large negative externality associated with the systemic risk presented by too-big-to-fail banks. The larger a bank gets, the less likely the government is to allow it to fail, and the more shielded it is from potential losses. Size therefore generates some significant social costs, particularly since the negative externality encourages firms to take on too much risk. A tax on bank size would get firms to internalise the social cost.

And if banks were to pass the cost of the tax on to customers, that might not be such a bad thing, given that it would give a relative price boost to smaller banks. Consumers are notoriously reluctant to change banks, a fact which reduces the beneficial effect of competition. But as with a carbon tax, the effect of the levy would be to reduce bank size, regardless of who bears the cost of the tax. Even though size and connectedness aren’t the be all and end all of systemic risk—leverage is key, as well—this kind of measure would be a positive step toward limiting systemic risk and moral hazard in the American banking system. And it would be another step toward a balanced budget. That’s a lot to like.